Embracing Private Markets, SWFs Thrive in Tough Times

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Source: Institutional Investor’s Sovereign Wealth
Center.

In a world of constrained capital, sovereign wealth funds are
investing more widely, capturing illiquidity premiums in
private markets and growing their assets under management. In
September, Institutional Investor’s Sovereign
Wealth Center examined what’s driving this
expansion and developed a ranking system for the
magazine’s fourth annual survey of the largest
sovereign funds. The 2013 ranking captures data for 46 funds,
proving that an increasing number of institutions that meet the
SWC’s rigorous definition of a sovereign wealth
fund.

As of December 31, 2012, those 46 funds managed a total of
$4.12 trillion in assets. Despite some of the toughest
investment conditions in a century, sovereign wealth funds had
boosted their assets from $2.35 trillion over the previous
five years, a compound annual growth rate of 11.8 percent on a
U.S. dollar basis. During the same period global pension
funds’ total assets under management only grew 3.2
percent compounded annually on a U.S. dollar basis, from
$25.9 trillion to $29.8 trillion, according to New
York–based professional services firm Towers Watson
& Co.

Between 2007 and 2012 the number of sovereign funds also
increased, from 39 to 46. All seven of the new funds except one
— Saudi Arabia’s Sanabil Investments
— were founded in 2011 and 2012. But at the end of
2012, these new funds only represented 0.3 percent
($12.9 billion) of total sovereign wealth fund assets.
Unlike China Investment Corp., founded in 2007 with
$200 billion, new funds commonly launch with the
equivalent of just a few hundred million dollars and receive
ongoing revenue from commodity extraction royalties. Although
oil prices have softened over the past two years, funds that
derive their capital from government oil and gas revenue
continued to dominate the total asset pool. In 2007 they
accounted for 57 percent of sovereign wealth
funds’ total assets under management, a proportion
that had dipped slightly, to 55.5 percent ($2.3 trillion),
by the end of 2012.

Funds that derive their capital from fiscal surpluses, such as
Singapore’s GIC (formerly Government of Singapore
Investment Corp.) and Korea Investment Corp., continued to
account for just over one third ($1.4 trillion) of total
assets, as they did in 2007. The outperformers were those whose
wealth derives from state-owned enterprises, like
Malaysia’s Khazanah Nasional and
Singapore’s Temasek Holdings, This group enjoyed
an average 14 percent compound annual growth rate: Their assets
under management swelled from 6 percent ($150 billion) of
sovereign wealth funds’ total in 2007 to 10
percent ($410 billion) in 2012.

Total Sovereign Wealth Fund Assets Under Management by
Funding Source

Source: Institutional Investor’s Sovereign Wealth
Center.

Looking at sovereign wealth fund assets through a geographic
lens reveals a picture of remarkable stability over the past
five years. In 2012 total assets were more or less equally
split among the Asia-Pacific (37 percent, or $1.53 trillion),
the Middle East and North Africa (35 percent, or
$1.45 trillion) and the rest of the world (28 percent, or
$1.13 trillion). Norway’s giant Government
Pension Fund Global (GPFG), which had $715 billion in
assets at the end of last year. The breakdown was broadly
similar in 2007, when the Asia-Pacific contributed 39 percent
of the $2.35 trillion total, MENA 37 percent and the rest
of the world 24 percent.

Total Sovereign Wealth Fund Assets Under Management by
Location

Source: Institutional Investor’s Sovereign Wealth
Center.

Given that commodity prices have fallen in recent years,
commodity revenue alone doesn’t account for the
strong performance of funds that rely on this funding. In
several cases governments diverted their oil and gas money to
shore up domestic economies during the financial crisis rather
than enrich the coffers of rainy-day funds. In the five years
since the crisis, sovereign wealth funds have doubled the
proportion of assets they invest in private markets such as
infrastructure, mezzanine debt, private equity, real estate and
venture capital, from 12.6 percent ($297 billion) in 2007
to 24 percent ($988 billion) in 2012. Sovereign wealth
funds financed this dramatic swing by shrinking their overall
allocation to cash and fixed income from 40.7 percent in 2007
to 29.4 percent in 2012. The proportion of their portfolios
invested in publicly listed equities remained constant at 46.7
percent.

Such a shift is perhaps unsurprising. Most sovereign wealth
funds have traditionally allocated to investment-grade
sovereign debt, which produced attractive returns with a low
risk profile before the crisis. But during the crisis
investors’ flight to safety drove down yields on
triple-A-rated government bonds, and the euro
zone’s subsequent troubles made these securities
scarcer.
So sovereign wealth funds have had to look elsewhere for yield.
Using their long-term investment horizons to harness
illiquidity premiums and improve long-term performance, they
decided that the private markets offered a better risk-return
proposition than its volatile public counterpart. Privately
owned assets were often undervalued, and there was little
competition for deals.

The financial crisis didn’t precipitate this
process, though. Between 2002 and 2007 sovereign wealth funds
had already started paring back their bond holdings and making
more private investments. But they did so much more slowly, as
part of a typical institutional investor life cycle that sees a
fund broaden its range of assets and take on more risk as it
gains experience.

Although sovereign wealth funds are growing rapidly, the
proportion of their assets available to external investment
managers declined from about 62 percent in 2007 to some 38
percent in 2012, according to SWC data. Funds are increasingly
insourcing investment management, especially in private
markets. In 2007 sovereign wealth funds invested a large
proportion of their approximately $300 billion worth of
unlisted assets with third-party managers. SWC estimates
suggest that this might have accounted for roughly 10 percent
of the private equity industry’s assets under
management, which London-based market research firm Preqin
valued at $2.2 trillion.

Many mature sovereign wealth funds, such as the Abu Dhabi
Investment Authority and Singapore’s GIC, are
making more of their private investments directly in private
markets so they can get closer to assets and have greater
influence over deal terms. Another incentive is the relative
management cost. Keeping private equity investments in-house
can be 5.5 times cheaper than using external managers,
according to Toronto-based global pension research firm CEM
Benchmarking.

The headline growth figures suggest a rich pool of assets for
external investment managers. But sovereign wealth funds
— many of which had never known a downturn before the
financial crisis hit, having launched during the boom years of
the mid-1990s — face a steep learning curve. As they
grow and develop, they seek to use asset managers to complement
internal capacity, provide training or augment knowledge
transfer.

Guidance from co-investment partners is proving particularly
important in private markets, where sovereign wealth funds are
becoming bolder investors. The more-mature sovereign wealth
funds are growing more discerning about which managers they use
and how they use them. For example, experienced funds often
choose to insource passive management in public markets and
enlist established outside managers for alpha generation.
Meanwhile, younger sovereign wealth funds continue to need
basic investment services. Although their assets are relatively
small, there’s great potential to develop new
partnerships with asset management firms that will become
closer and richer over time.

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